Evaluating Investment Performance

Choosing investments is just the beginning of your work as an investor. As time goes by, you'll need to monitor the performance of these investments to see how they are working together in your portfolio to help you progress toward your goals. Generally speaking, progress means that your portfolio value is steadily increasing, even though one or more of your investments may have lost value.

If your investments are not showing any gains or your account value is slipping, you'll have to determine why, and decide on your next move. In addition, because investment markets change all the time, you'll want to be alert to opportunities to improve your portfolio's performance, perhaps by diversifying into a different sector of the economy or allocating part of your portfolio to international investments. To free up money to make these new purchases, you may want to sell individual investments that have not performed well, while not abandoning the asset allocation you've selected as appropriate.

How Are My Investments Doing?

To assess how well your investments are doing, you'll need to consider several different ways of measuring performance. The measures you choose will depend on the information you're looking for and the types of investments you own. For example, if you have a stock that you hope to sell in the short term at a profit, you may be most interested in whether its market price is going up, has started to slide, or seems to have reached a plateau. On the other hand, if you're a buy-and-hold investor more concerned about the stock's value 15 or 20 years in the future, you're likely to be more interested in whether it has a pattern of earnings growth and seems to be well positioned for future expansion.

In contrast, if you're a conservative investor or you're approaching retirement, you may be primarily interested in the income your investments provide. You may want to examine the interest rate your bonds and certificates of deposit (CDs) are paying in relation to current market rates and evaluate the yield from stock and mutual funds you bought for the income they provide. Of course, if market rates are down, you may be disappointed with your reinvestment opportunities as your existing bonds mature. You might even be tempted to buy investments with a lower rating in expectation of getting a potentially higher return. In this case, you want to use a performance measure that assesses the risk you take to get the results you want.

In measuring investment performance, you want to be sure to avoid comparing apples to oranges. Finding and applying the right evaluation standards for your investments is important. If you don't, you might end up drawing the wrong conclusions. For example, there's little reason to compare yield from a growth mutual fund with yield from a Treasury bond, since they don't fulfill the same role in your portfolio. Instead, you want to measure performance for a growth fund by the standards of other growth investments, such as a growth mutual fund index or an appropriate market index. Here are some concepts to consider when evaluating the performance of your investments including yield, rate of return and capital gains and losses.

Yield is typically expressed as a percentage. It is a measure of the income an investment pays during a specific period, typically a year, divided by the investment's price. All bonds have yields, as do dividend-paying stocks, most mutual funds, and bank accounts including CDs.

Yields on Bonds: When you buy a bond at issue, its yield is the same as its interest rate or coupon rate. The rate is figured by dividing the yearly interest payments by the par value, usually $1,000. So if you're collecting $50 in interest on a $1,000 bond, the yield is 5 percent. However, bonds you buy after issue in the secondary market have a yield different from the stated coupon rate because the price you pay is different from the par value. Bond yields go up and down depending on the credit rating of the issuer, the interest rate environment and general market demand for bonds. The yield for a bond based on its price in the secondary market is known as the bond's current yield. For more information on bond yields, see Bond Yield and Return.

Yields on Stocks: For stocks, yield is calculated by dividing the year's dividend by the stock's market price. You can find that information online, in the financial pages of your newspaper and in your brokerage statement. Of course, if a stock doesn't pay a dividend, it has no yield. But if part of your reason for investing is to achieve a combination of growth and income, you may have deliberately chosen stocks that provided a yield at least as good as the market average. However, if you're buying a stock for its dividend yield, one thing to be aware of is the percentage of earnings that the issuing company is paying to its shareholders. Sometimes stocks with the highest yield have been issued by companies that may be trying to keep up a good face despite financial setbacks. Sooner or later, though, if a company doesn't rebound, it may have to cut the dividend, reducing the yield. The share price may suffer as well. Also remember that dividends paid out by the company are funds that the company is not using to reinvest in its businesses.

Yields on CDs: If your assets are in conventional CDs, figuring your yield is easy. Your bank or other financial services firm will provide not only the interest rate the CD pays, but its annual percentage yield (APY). In most cases, that rate remains fixed for the CD's term.

Your investment return is all of the money you make or lose on an investment. To find your total return, generally considered the most accurate measure of return, you add the change in value—up or down—from the time you purchased the investment to all of the income you collected from that investment in interest or dividends. To find percent return, you divide the change in value plus income by the amount you invested.

Here's the formula for that calculation:

(Change in value + Income) ÷ Investment amount = Percent return

For example, suppose you invested $2,000 to buy 100 shares of a stock at $20 a share. While you own it, the price increases to $25 a share and the company pays a total of $120 in dividends. To find your total return, you'd add the $500 increase in value to the $120 in dividends, and to find percent return you divide by $2,000, for a result of 31 percent.

That number by itself doesn't give you the whole picture, though. Since you hold investments for different periods of time, the best way to compare their performance is by looking at their annualized percent return.

For example, you had a $620 total return on a $2,000 investment over three years. So, your total return is 31 percent. Your annualized return is 9.42 percent. This is derived by doing the following calculation: (1+.31)(1/3) - 1 = 9.42 percent. The standard formula for computing annualized return is AR=(1+return)1/years- 1.

If the price of the stock drops during the period you own it, and you have a loss instead of a profit, you do the calculation the same way but your return may be negative if income from the investment hasn't offset the loss in value.

Remember that you don't have to sell the investment to calculate your return. In fact, figuring return may be one of the factors in deciding whether to keep a stock in your portfolio or trade it in for one that seems likely to provide a stronger performance.

In the case of bonds, if you're planning to hold a bond until maturity you can calculate your total return by adding the bond income you'll receive during the term to the principal that will be paid back at maturity. If you sell the bond before maturity, in figuring your return you'll need to take into account the interest you've been paid plus the amount you receive from the sale of the bond, as well as the price you paid to purchase it.

Whatever type of securities you hold, here are some tips to help you evaluate and monitor investment performance:

Don’t forget to factor in transaction fees. To be sure your calculation is accurate, it's important to include the transaction fees you pay when you buy your investments. If you're calculating return on actual gains or losses after selling the investment, you should also subtract the fees you paid when you sold.

Review and understand your account statements. In addition to fees, your account statement—specifically the Account Summary section—offers a high-level picture of your account performance from the end point of the previous statement, including the total value of your account. For more information, read FINRA’s Investor Alert, It Pays to Understand Your Brokerage Account Statements and Trade Confirmations.

Calculate total return. If you reinvest your earnings to buy additional shares, as is often the case with a mutual fund and is always the case with a stock dividend reinvestment plan, calculating total return is more complicated. That's one reason to use the total return figures that mutual fund companies provide for each of their funds over various time periods, even if the calculation is not exactly the same result you'd find if you did the math yourself. One reason it might differ is that the fund calculates total return on an annual basis. If you made a major purchase in May, just before a major market decline, or sold just before a market rally, your result for the year might be less than the fund's annual total return.

Consider the role of taxes on performance. Computing after-tax returns is important. For example, interest income from some federal or municipal bonds may be tax-exempt. In this case, you might earn a lower rate of interest but your return could actually be greater than the return on taxable bonds paying a higher interest rate. It’s especially important to figure after-tax returns in taxable accounts. This is often helpful to do with a tax professional. You may find that the gains made in a taxable account are not as robust as you thought, leading you to consider other investments for your taxable accounts (for instance investments that appreciate in value, but don’t pay income that can itself be taxed).

Factor in inflation: With investments you hold for a long time, inflation may play a big role in calculating your return. Inflation means your money loses value over time. It's the reason that a dollar in 1950 could buy a lot more than a dollar in 2015. The calculation of return that takes inflation into account is called real return. You'll also see inflation-adjusted dollars called real dollars. To get real return, you subtract the rate of inflation from your percentage return. In a year in which your investments returned 10 percent but inflation sent prices rising three percent, your real return would be only seven percent.

As you gain experience as an investor, you can learn a lot by comparing your returns over several years to see when different investments had strong returns and when the returns were weaker. Among other things, year-by-year returns can help you see how your various investments behaved in different market environments. This can also be a factor in what you decide to do next.

However, unless you have an extremely short-term investment strategy or one of your investments is extremely time-sensitive, it's generally a good idea to make investment decisions with a view to their long-term impact on your portfolio rather than in response to ups and downs in the markets.

Investments are also known as capital assets. If you make money by selling one of your capital assets for a higher price than you paid to buy it, you have a capital gain. In contrast, if you lose money on the sale, you have a capital loss. Capital gains and losses may be a major factor in your portfolio performance, especially if you are an active investor who buys and sells frequently.

In general, capital gains are taxable, unless you sell the assets in a tax-free or tax-deferred account. But the rate at which the tax is calculated depends on how long you hold the asset before selling it.

Profits you make by selling an asset you've held for over a year are considered long-term capital gains and are taxed at a lower rate than your ordinary income. However, short-term gains from selling assets you've held for less than a year don't enjoy this special tax treatment, so they're taxed at the same rate as your ordinary income. That's one reason you may want to postpone taking gains, when possible, until they qualify as long-term gains.

With some investments, such as stocks you own outright, you can determine when to buy and sell. You will owe taxes only on any capital gains you actually realize—meaning you've sold the investment for a profit. And even then you may be able to offset these gains if you sold other investments at a loss. With other investments, capital gains can become more complicated.

Mutual funds, for example, are different from stocks and bonds when it comes to capital gains. As with a stock or a bond, you will have to pay either short- or long-term capital gains taxes if you sell your shares in the fund for a profit. But even if you hold your shares and do not sell, you will also have to pay your share of taxes each year on the fund's overall capital gains. Each time the managers of a mutual fund sell securities within the fund, there's the potential for a taxable capital gain (or loss). If the fund has gains that cannot be offset by losses, then the fund must, by law, distribute those gains to its shareholders.

If a fund has a lot of taxable short-term gains, your return is reduced, which is something to keep in mind in evaluating investment performance. You can look at a mutual fund's turnover ratio, which you can find in a mutual fund's prospectus, to give you an idea of whether the fund might generate a lot of short-term gains. The turnover ratio tells you the percentage of a mutual fund's portfolio that is replaced through sales and purchases during a given time period—usually a year.

Unrealized gains and losses—sometimes called paper gains and losses—are the result of changes in the market price of your investments while you hold them but before you sell them. Suppose, for example, the price of a stock you hold in your portfolio increases. If you don't sell the stock at the new higher price, your profit is unrealized because if the price falls later, the gain is lost. Only when you sell the investment is the gain realized—in other words, it becomes actual profit.

This is not to say that unrealized gains and losses are unimportant. On the contrary, unrealized gains and losses determine the overall value of your portfolio and are a large part of what you assess in measuring performance, along with any income generated by your investments. In fact, many discussions of performance in the financial press, especially regarding stocks, focus entirely on these price changes over time.